Wednesday, 25 January 2012

UK Growth reveals a major macroeconomic policy error

The first estimate of UK growth in the last quarter of 2011 was negative. As these updated NIESR charts show, no other UK recovery has stalled in this way. Of course very little is ever certain, but we can be pretty sure that growth would have been significantly better if the current government had not imposed severe additional austerity measures beginning in 2010. (This is the counterfactual that matters, and just looking at GDP components can be a misleading way at getting at this for reasons I discussed here.) Of course growth might have been better too if the Euro crisis had not happened, but this government had no control over the Euro crisis, while it does decide fiscal policy.

I do not have anything very new to say about this, in part because many people predicted growth would be harmed before the policy was introduced. (See, for example, this letter from 80 economists published during the 2010 election campaign.) What was the reason for this major macroeconomic policy error? For some I think it was a political calculation that it would be advantageous to get as much of the cuts out of the way early, well before the next general election. However I think others in the coalition were genuinely spooked by events in Greece and elsewhere. Unfortunately the key difference between economies in the Eurozone and those with their own central bank was not appreciated. Today the claim that if these additional austerity measures had not been introduced UK interest rates on debt would have suffered the same fate as many Eurozone countries looks pretty implausible. In Denmark we even have an example of a country that has recently undertaken stimulus measures, and where interest rates have continued to fall in line with other countries outside the Eurozone (see David Blanchflower here).

So I believe we must add 2010 to a list of major macroeconomic policy errors made in the UK since the war. Like the failed monetarist experiment in the early 1980s, it is the result of a government adopting a policy which relied on a mistaken macroeconomic analysis that was not supported by the majority of academic opinion. And like that earlier failure, it will leave unemployment significantly higher than it need to have been for many years.

8 comments:

The macro policy error was sticking with inflation targeting. Inflation targeting was expected to cope badly with supply shocks, and lo, it has been demonstrated.

The MPC think high inflation means demand is growing too fast. They are programmed that way, and they came close to raising rates in the first half of 2011 in response.

The December minutes show they are still worried about lack of supply capacity, seeing the balance of risk for demand growth being about right, that faster demand growth might just be inflationary.

They repeat time after time that they are able to boost nominal spending with more QE, but *they do not see it as necessary*. They do not *want* faster spending growth in the UK. Tell me now about macro policy errors?

The abject failure of inflation targeting to stabilise either output or demand from 2008-2011 should be main debate for all macroeconomists, yet most are silent, complaining only about fiscal policy "not doing enough" despite record levels of deficit spending.

If the government wants faster spending growth in the UK they need to change the monetary policy mandate or replace the MPC.

Where I agree is that monetary policy became needlessly worried about inflation last year, with at one point 3/9 voting to raise rates. At the time I was horrified about this, as this (http://www.economics.ox.ac.uk/members/simon.wren-lewis/#_Ten_reasons_not) from my website demonstrates. Where I disagree is with the idea that monetary policy alone was capable of dealing with the problem - I think the zero lower bound is a serious restriction on what monetary policy can do.

2. The government does understand basic macroeconomics, but does not believe that it is relevant to the current circumstances

3. The government does understand basic macroeconomics, believes that austerity may be economically damaging, but persists in the policy for political reasons

Now, David Cameron has a 1st in PPE from Oxford, so I would assume he is aware of the basic Keynesian model. I believe William Hague is similarly qualified. I don't think the government's economic knowledge is as great as it could be, but it can't just be a question of ignorance.

I think it is more likely that they believe their knowledge of economics is incomplete or not relevant. They remember the 364 economists, and are influenced by economists and financiers who favour austerity (remember, Mervin King endorsed the coallion's plans over Labour's). I think there is a strong sense amongst conservatives that they were right in the 1980s and they are right today, whatever the majority of economists may say.

Finally, I don't think we can ignore the possibility that government is (somewhat cynically) using the opportunity to cut public spending. Since Labour left us with a big government and a structural deficit, maybe this is the right approach. It seems to be based on the idea that people will not accept cuts in good times, even though that may be the optimal approach from an economic perspective. Politics is the art of the possible, and all that!

@econojon. Osborne has stated several times that he believes monetary policy is the appropriate tool for aggregate demand management, and has hence continued the policy of delegating AD management to the Monetary Policy Committee. (The MPC also think they are perfectly able to manage AD despite being at the ZLB)

Well, if you were paying attention you would have seen that I ruled out the possibility of ignorance as implausible, given the education of the PM and other members of the cabinet. I think this falls under category 2, essentially Osbourne is rejecting Keynesian economics in favour of monetarism.

It's true that the criticism of the Government's policy from people like Simon and Paul Krugman is a little one-sided. For example, if the cuts in spending are perceived as permanent, there may be no negative impact on demand. And it is at least possible that QE can be used to manage demand. Moreover, unlike the US we have been experiencing excessive inflation, and it's by no means obvious that demand should be further stimulated in such circumstances. On the other hand, the Government's obsession with deficit-reduction seems wrong-headed in the circumstances. How about some supply-side tax cuts to get the economy moving, a la Reagan?

I think the present government misjudged the economy when it came to office. They believed that the economy was beginning to recover from the 2008/9 recession and that unwinding the fiscal stimulus that Labour had applied was therefore the right thing to do. Had their judgement of the economy been correct, cutting public spending would indeed have been the right thing to do. But they ignored the effect of the overhang of private debt. Cutting public spending when a highly-indebted private sector was trying to deleverage was the wrong thing to do, especially as the impending crisis in the UK's major export market (the Eurozone) threatened exports. Additionally, the Government has paid little attention to demand collapse, even though it is evident that this is a serious problem in the domestic economy at the moment. Instead, they have focused on supply-side reforms and assumed that if supply is improved, demand will respond - despite the evidence that people simply do not want to spend at the moment. The only demand stimulus they are prepared to give is to the financial sector in the form of QE. I suspect this is ideological.

There is a trivial error of logic in this analysis. The reasoning seems to be that, because growth seems to be weak and to coming out lower than the OBR originally forecast, that therefore the Chancellor must have made a 'major macroeconomic policy error' in 2010.

Since there are important external factors which have worsened in the meantime, most notably unexpectedly high commodity prices and the crisis in the Eurozone, the fact of weak growth in no way demonstrates that those who "predicted growth would be harmed before the policy was introduced" were right. All it demonstrates is that world economic conditions have been more unfavourable than most observers expected, not that the 2010 policy was to blame.

Furthermore, it is eccentric in the extreme to point to Denmark as a counter-example. Denmark entered the financial crisis with exceptionally healthy public finances and running a surplus. It is now running a deficit (around 4.6% of GDP in 2012) which is modest by UK standards. Of course if the UK's finances were in as good a state as Denmark's, it would make sense to follow their example and increase borrowing a bit to provide some stimulus and smooth out the worst effects of the downturn. But when you start from a position where borrowing is already excessive, the trade-off is completely different.

On your first point, the reasoning is that austerity reduced demand. Now, I think Frances above is right that the government hoped other factors would offset this, but part of this hope might well have been an erroneous belief that fiscal contraction would not have much if any influence on output. That belief was wrong. I also think that growth would have been too slow even if the unfavourable events you mentioned had not occurred, so again they were wrong. But their worst mistake was to ignore the asymmetric nature of the risks involved. If, as happened, world events turned out worse than they expected, they had no insurance policy. If things had turned out better than they expected, and growth really was too fast, monetary policy could be used to deflate demand. See my later post http://mainlymacro.blogspot.com/2012/02/budget-deficits-changes-levels-and.html. My point on Denmark is that the market has shown no reaction to their stimulus package. The implied non-linearity here is very strange: no impact on interest rates of higher debt until some magic level, when all hell breaks loose, and that magic level just happens to be where the UK is now.

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